Safety Stock & Re-order points – simple explanation

Safety stock is the additional number of units of stock held by a company to mitigate several market risks. Without safety stocks, the company could have negative customer experience, lost revenue, lost market share and long-term customer value. However, a higher safety stock strains the organization in the form of higher working capital requirement. Safety stocks help in mitigating several risks as below:

A Sudden spike in demand

Offset inaccurate forecasts

Longer than expected lead times to delivery (from the supplier)

Quality issue rejects of stock, leading to stock-outs

Increase in manufacturing or production time

Transportation strikes or non-availability of transport

Warehouse space issues due to which inbound gets delayed

So, how does one calculate the safety stock needed for an item?

The answer is that there is no one definite way of calculating the safety stock required. One shouldn’t use the available formulas blindly as the specific case of each company x product x market is very different.

Method 1: Let’s start with intuition (I love intuition!).

Intuitively, safety stock is designed to cover for maximum delays in delivery from the supplier. So, what can be the maximum delay from a supplier that you want to guard against – it is the maximum lead time minus the average lead time from the supplier.

A toys company deals in one single toy and procures from a single supplier and has an annual demand of 4000 units of a single toy. The cost of placing an order is Rs. 50 each time with the annual costs of holding the toy being at 40 % of the purchasing cost. The company purchases the toy at Rs. 120 per unit. How much should the company order at a time?

EOQ= √ (2*CO *D)/CH

EOQ= √(2*50*4,000)/(0.4*120)

EOQ= √(400,000)/(48)

EOQ= 28.87 units

Method 3: Formula used in SAP ERP system

A buffer stock or safety stock has to be designed to cover various deviations. A delay in any of the lead times mentioned below affects the procurement pattern.

ordering lead time

manufacturing lead time

transportation lead time

stock conversion lead time (inward lead time or QC clearance lead time)

Moreover, the determination of safety stock depends on the forecast accuracy. Higher the accuracy, lower the safety stock requirement. Hence, we have the below

Now, if replenishment lead time is greater than the forecast period by factor W then:

Safety Stock = R x Sq.rt. W x MAD

Else

Safety Stock = R x W x MAD

Method 4: Safety stock should cover supply and demand variability

Safety stock should have two components: supply safety stock and demand safety stock.

Demand safety stock = k*sd(forecast error)*sqr rt(lead time)

k = factor for number of std deviations required for given service level (refer link)

Supply safety stock = k*std dev lead time

Total safety stock = sqrt( demand safety stock + supply safety stock)

As you saw from the above methods, there is no one clear way of calculating safety stocks. It depends on a whole range of parameters such as lead times, forecast periods, order cycle times, forecast accuracy, service levels, lead time variances and others. Therefore, it is very important to test and observe the trends of all variables periodically to ensure that the best safety stock values are used by the firm.